Tuesday, February 22, 2011

There has been an increase in the hawkishness by some ECB members, be it Bini-Smaghi last week or Mersch today . With the next ECB meeting being one week away, the ECB council seems to be moving towards the view that inflation risks are rising whereas the recovery becomes more sustained - at least in the core countries and given the relative size, also for the Eurozone average. It remains my opinion that the ECB will raise rates by June (see A higher ECB repo rate by June dated Feb 2) but keep liquidity provision ample. As the chart below shows, the peripheral markets have calmed down. 10y Spanish, Italian and Belgium yields have stopped rising and moved in a range over the past months.

10y peripheral yields have stopped rising, except in Portugal

Source: Bloomberg

Only the Portuguese situation has continued to worsen. To me it looks like the other Eurozone countries are trying to force Portugal into a bail-out while at the same time announce the overhaul of the EFSF. Such a solution could - if done properly - lead to a further calming in the peripheral crisis. Furthermore, an overhauled EFSF would be acting like a second monetary institution alongside the ECB but effectively be in charge of long-term peripheral yields. As a result, the ECB can concentrate again on its main policy tools - the repo rate and liquidity provision.

Wednesday, February 2, 2011

It is my belief that the ECB will start its next rate hiking cycle by June this year. The 1% repo rate was established in an environment where the Eurozone economy was contracting sharply and in combination with the financial market crisis threatened a deflationary depression. In the meantime, the aggregate Eurozone data show that growth has recovered back to around trend whereas headline inflation has moved above 2% and also core inflation rate is on the rise again after having hit a low in mid 2010. Furthermore, credit availability is on the rise again (see also Monetary developments in the Eurozone will soon call for higher rates dated 28 January). As a result, monetary policy is getting even more accommodative!

However, neither the state of financial markets, nor the real economy are warranting this exceptionally low repo rate much longer and the ECB should start to remove some of its accommodation via raising the repo rate. On the other side, the banking sector is still depending on the ECB’s liquidity provision measures and its weak solvability suggests that this will remain the case for longer. In turn, the ECB can continue to provide ample liquidity – but at a higher price – to support the banking sector. Finally, a reformed EFSF can be established as a second monetary authority besides the ECB with the aim of capping bond yields of fundamentally weak countries. I have long been of the opinion that a substantial bond buying programme by the ECB/EFSF could break the adverse feedback loop in the periphery (higher yields worsen the budget deficit and are a headwind for the economy, both acting to worsen the already poor fundamental outlook and driving away bond investors, leading yields even higher). In fact, if done in a sensible manner, the EFSF could start a virtuous circle whereby lower peripheral bond yields reduce the deficit (via lower interest rate payments) and weaken the restrictive monetary environment for the peripheral economies, thereby helping growth. This in turn will improve the fundamentals for the peripheral credits and help to bring back private investors into the market, further lowering yields.

Policy tool

Direction

Expected stance

Repo rate (ECB)

Higher

Less accommodative

Liquidity provision (ECB)

Unchanged

Ample liquidity

Peripheral bond yields (EFSF)

Lower

Less restrictive

Overall, I expect that we will be left with a higher repo rate (a less accommodative environment for the core countries), lower peripheral bond yields (a less restrictive monetary environment for the peripheral countries) but an environment where liquidity continues to be ample.

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About Me

Daniel was Head of Economics & Strategy for developed markets at Dresdner Kleinwort until early 2009 and was responsible for the well-known 'Ahead of the Curve' flagship publication. He started as a Desk Analyst in the mid-90s for the former German government bond trading desk. He then became Head of Rates Strategy early last decade and later on also took responsibility for G10 economics, commodities strategy and asset allocation.
He is now the owner of Research Ahead GmbH located in Frankfurt am Main.

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